The United States vetoed an Arab-sponsored UN resolution branding Israeli settlements illegal, prompting angry Palestinians to vow to re-evaluate the entire Middle East peace process.

The Obama administration cast its first veto in the United Nations Security Council after intense diplomacy failed to convince Palestinians to accept a non-binding compromise statement condemning Jewish settlement activity.

The row dealt a further blow to Washington's already struggling bid to forge a Palestinian state this year and risked further estranging US ties with Arab leaders already tetchy at its response to unrest sweeping the Middle East.

US ambassador to the UN Susan Rice said Washington was "regrettably" blocking the draft resolution and warned Israeli should not interpret the move as backing for settlement building in east Jerusalem and the West Bank.

But she said the United States -- one of five permanent Security Council members with veto power -- did not believe the United Nations was the best place to seek to resolve the decades-old Israeli-Palestinian conflict.

"This draft resolution risks hardening the positions of both sides," Rice said. "It could encourage the parties to stay out of negotiations."

Later, in a conference call with reporters, Rice added "We reject in the strongest terms the legitimacy of the continued Israeli settlement activity."

But Yasser Abed Rabbo, secretary general of the Palestine Liberation Organization (PLO), said the US veto was "unfortunate and affects the credibility of the American administration."

As a result, the Palestinians will "re-evaluate the entire process of negotiations" towards peace in the Middle East, he said.

The resolution, sponsored by 130 countries, reaffirmed "that the Israeli settlements established in the Palestinian Territory occupied since 1967, including East Jerusalem, are illegal and constitute a major obstacle to the achievement of a just, lasting and comprehensive peace."

It also reiterated "its demand that Israel, the occupying power, immediately and completely ceases all settlement activities in the Occupied Palestinian Territory."

Washington, although saying it views settlement activity as illegitimate, has stopped short of declaring it "illegal" saying that doing so could add further complications to future final status peace talks.

The Palestinians balked at the US compromise despite intense diplomacy by President Barack Obama and Secretary of State Hillary Clinton.

The row came at some political as well as diplomatic cost to the administration as it took incoming fire from bi-partisan lawmakers who support Israel for even offering a compromise solution.

Fourteen of the 15 Security Council members voted in favor of the resolution but the US veto effectively killed the move.

Israel reacted to the veto by calling for a resumption of direct talks with the Palestinians.

Prime Minister Benjamin Netanyahu said in a statement that "Israel deeply appreciates the decision by President Obama to veto the Security Council resolution."

"Israel remains committed to pursuing comprehensive peace with all our neighbors, including the Palestinians," it said.

"We seek a solution that will reconcile the Palestinians' legitimate aspirations for statehood with Israel's need for security and recognition."

The last round of peace talks broke down late last year after the expiry of an Israeli settlement building moratorium.

Palestinian leaders say peace talks are impossible with construction taking place which they say undermines the territorial integrity of their future state.

The United States has traditionally used its veto power in the Security Council, a body Israel deems as deeply biased, to shield the Jewish state from censure.

Palestinian president Mahmud Abbas on Friday turned down a request by Obama to withdraw the motion for condemnation and settle instead for a council statement calling for an Israeli settlement freeze.

One senior Palestinian official, speaking on condition of anonymity, told AFP the offer, made in an hour-long phone call late Thursday from Obama, was accompanied by veiled threats of "repercussions" if it were refused.

Rice had proposed a three-fold package of incentives for Palestinians: a non-binding Security Council statement condemning settlement activity, a visit by a UN Security Council delegation to the region and a Mideast Quartet statement referring to 1967 borders in reference to a Palestinian state.